Preparing for Dealing with the Lender or Investor

Factors to Consider When Preparing for a Lender

The Five C's of Credit

Detailed Questions for the Borrower

Five Questions Every Money Source Asks

How Lenders Perform A Credit Analysis on a Borrower

Loan Risk Rating Standards

Indicators of Problem-Type Loans

Warning Signs Lenders and Investors Look for

Twelve Problem-Borrower Types

Summary Bullets of Important Information the Lender will Look for



Preparing for Dealing with the Lender or Investor

Every entrepreneur has to confront five questions asked by sophisticated providers of cash. The answers have to be the right ones, not merely answers. Nonetheless, even the right answers may lead to turndowns. But turndowns can be turned around when one understands something about turndowns. These five questions can and should be effectively answered in the business loan proposal or plan.

Although an investor or lender may favor certain industries, such as oil and gas or high technology, these preferences are frequently set aside to make room for exciting exceptions. The exceptional deal provides the right answers to the five questions that an investor asks each time he reads a new business plan.

1. How much can I make?

2. How much can I lose?

3. How do I get my money out?

4. Who says this deal is any good?

5. Who else is in the deal?

Remembering the three basic tests for creditworthiness are also important when dealing with lenders. They are as follows:

1. Adequate owner's equity and unencumbered assets

2. Sufficient earning power and/or cash flow to repay the loan, with a generous margin of safety

3. Confidence in the business ability and integrity of the management and owners.

Insight is the attribute that sets apart and is your most valuable asset, and it can be applied to every situation; indeed, it must be applied if you want to stay in business. Consider how this applies to the question of borrowing money: The only way to gain the advantage is to thoroughly understand the risks from a lender's point of view.

Follow these rules for beginning the process of borrowing money.

Work from a complete plan. Lenders will want to know how you intend to use the money you borrow. You must be prepared with a complete plan, designed to prove that the risk of lending money to you is low and that you have a timetable and a method for producing profits with the borrowed funds.

Develop a repayment schedule. You must be also prove your ability to repay the loan. Most borrowers overlook this fundamental requirement. The lender cannot be expected to know all about your cash flow or future profits; chances are, the lender knows very little about your business. So it is your task to show how operations will free up the money you will need to make timely payments. Prove you plan's validity. Your plan must be completely accurate and valid. Anyone can develop the numbers to show their future success; realizing it is not always possible. Test your plan, challenge your own assumptions, and develop a "worst-case" example of the future. Show the lender how you plan to deal with risks and how you will ensure your own success.

Eliminate the lender's risks. The best way to get approval of your loan application is to identify and then eliminate the lender's risks, the greatest of which is that you will not repay your loan. Show that this will not occur, because your plan is conservative, farsighted, and realistic.

Understand the lender's criteria. Before submitting your application, meet with the loan officer. Find out how they evaluate loan requests, what information they look for, and the preferred organization of a business plan. Identify the criteria for making a decision, and then address those criteria in your proposal.

The first step in finding a likely lender must be to first identify the lenders who want to grant the type of loan you seek in the same way that you identified a market when you opened your own business. As a rule, every lender will apply the same basic tests to every loan application. There are five or six generally understood criteria, known as the "five or six C's of Credit" (covered in more detail later in this guide):

Character. How do you view borrowing? Have you developed a business plan that demonstrates your ability to plan ahead, arrange for repayment of your debt, and take your responsibilities seriously?

Capacity. Do you possess the experience, talent, and responsibility to handle money well, repay the loan, and appreciate the lender's risks?

Capital. What have you invested in your own business? No lender will carry all of your financing; they want you to have a vested interest in succeeding.

Conditions. That type of business are you in? Is volume and cash flow seasonal? How much money is owed to you, and what portion is current? What is your competitive posture?

Collateral. Most business loans will be granted on a secured basis. The lender will want to be able to assume ownership of some asset in the event you are unable to repay your loan. An unsecured loan will be granted only in those cases when credit is well-established and you can demonstrate your solvency.

Coverage. This is sometimes added as a sixth test, to cover the risks lenders face, not only in the event of a reversal in your business, but as the consequence of an unexpected loss. These risks include the business owner's death, disability, or poor health; casualty or theft of business property; and liability in dealing with customers. A lender may require you to assign a life insurance policy, arrange for credit life insurance, or inquire into other forms of coverage you hold.

Lenders react poorly to would-be borrowers who take a negative approach when asking for a loan. The successful loan applicant should look for and discuss the truly positive reasons for borrowing. When a business owner tell the loan officer the reason for seeking a loan is to "consolidate debts", the business owner is really admitting to having fallen into debt well beyond his/her capacity to manage it. The lender will then wonder whether the owner has the management skill and foresight to ensure prompt and timely repayment of the new loan.

The alternative is to develop a plan that show how debt will be managed properly. This includes any existing loans, as well as a new loan. It also includes the recurring costs and overhead of the operation, purchase of new equipment, investment in inventory or a larger average balance of accounts receivable. and a higher level of permanent spending resulting from expansion.

Borrowers also make the mistake of assuming very rapid growth in a short period of time, believing that the greater the potential for growth, the more compelling the case for loan approval. However, lenders are usually more conservative about the market potential, and do not have the same amount of appreciation or enthusiasm for it. Therefore, expansion plans should be expressed in
conservative terms - perhaps more conservatively than is initially desired by the borrower.

Another point to cover here involves increased income versus coverage of costs and expenses. The lender is told that loan proceeds will be used to pay direct costs and operating expenses while marketing and sales are increased. This will probably not reassure the lender, because the question remains: Where will the money come from for repayment? The answer might be obvious to the borrower, but the risk of granting a loan based on that argument might be too great for the lender.

An alternative is to demonstrate how the use of proceeds will increase profits. This is saying the same thing as "covering costs and expenses." but it stresses the bottom line. To the lender, greater profits mean greater cash flow - and reduced risk.

The borrower should not make the mistake of telling a lender that a loan will solve cost and expense control problems. Not only is that claim untrue; it will set off an alarm bell that could cost the borrower the approval  for the loan. Instead, the lender should be shown how controls have been instituted to track and reduce cost and expense levels - in anticipation of expansion. This will 
greatly reassure the lender. These positive and negative approaches are compared in the following table.

Positive Approach: 

• debts will be managed within the plan 

• growth will occur methodically, within the plan's limits

• money will be spent to increase profits

• controls have been instituted to track cost and to reduce reduce costs and expense levels

Negative Approach:

• money is needed to consolidate debts

• a loan will help the business grow rapidly

• money will be used to cover existing costs and expenses

• cost and expense control problems will be solved by borrowing 

Following these guidelines will improve the borrower's chances of loan or investment approval and make the lender's or investor's job easier. A properly completed application, along with all the other documentation and paperwork will demonstrate that the borrower is indeed well organized, clear thinking, well-prepared, and knowledgeable about what it takes to request the financing.

These positive traits portray the borrower as a good risk in several respects. The lender or investor will naturally assume that a well organized, complete application will be submitted by the business owner who is equally as thorough in every other respect, such as preparation and research for the business plan, awareness of risks, and timing of a loan or investment request.

Anticipation of problems that the lender/investor might see and preparing an answer for them as part of your application is extremely important. This can be achieved in a cover letter or with a supplemental schedule. For example, if the borrower has a current loan and the new financing proposed will not refinance it, then a detailed explanation is necessary describing the revenues and cash flow to repay both the new financing and the current loan.

The borrower should show the lender/investor that he/she is completely aware of risk from both sides of the issue. Directly confront and anticipate the question of the lender's risk. The financing documentation should not only demonstrate how the borrower's risks will be reduced, but also how the lender/investor's risk are accounted for and mitigated. This will surely please the lender or investor.

The lender/investor will be reassured when shown the borrower's competitive advantage, or the answer to the question: "Why will anyone buy from the you?" Common sources of competitive advantage include the following:

• Location providing greater convenience to customers, reduced transportation costs, lower operating expenses, or better visibility and traffic flow.

• Specialization reflected in the depth of product lines and the sophistication and knowledge of sales personnel.

• Product line breadth and exclusivity resulting from protected distributor relationships and/or multiple vendors and broad inventory holdings.

• After-sale support in terms of warranty, repair and service, delivery, installation, and floor-plan financing Cost position resulting from more efficient production, more favorable supply terms, lower overhead expenses, or avowed "meet the competition" pricing.

• Channels of distribution that are unique in that they offer customer convenience or cost savings for both the borrowing business and its customers.

• Product quality due to exacting production standards, superior raw materials, or careful selection of brand name manufacturers as vendors.

• Customer base representing established long-term relationships with loyal purchasers. This is particularly valuable in product line additions where cross-selling is important.

Factors to Consider When Preparing for a Lender

No matter which lender/investor is used or where financing is obtained, certain business and personal financial data will be needed. The exact nature of the data will depend on the particular lending institution, but all lenders will want, more or less, the same kind of facts.


1. Most lenders use the five "C's" of credit as a rule- of-thumb on loans (see next section):

• Character

• Capacity

• Capital

• Conditions

• Collateral

2. Basic financial data that should be developed:

• Prepare a personal financial statement.

• Determine your current net worth.

• Determine how much cash you can invest in your business/project.

• If existing, prepare business financial statements.

• If new, estimate "start-up" costs of your business.

• Estimate the business/project expenses for the next year.

• Estimate the total cash requirements for the next year.

• Determine the amount of money needed for the loan/investment.

• Estimate the breakeven point.

• Decide on what action will be taken if more funds are needed.

• Prepare a thorough business plan.

3. These questions should be answered beforehand:

• Why is this capital needed?

• How much money is required?

• When is the money needed?

• For how long is the capital required?

• Where will the money be obtained?

• How will the money be repaid?

4. Tips for developing good financial management:

• Plan all capital requirements.

• Balance equity and debt properly.

• Avoid excessive fixed assets.

• Maintain adequate working capital.

• Avoid excessive inventories.

• Do not borrow more than what is needed.

The Five C's of Credit

Character

Character refers to the borrower's willingness and determination to meet a loan obligation. Character is probably the single most important component of a borrower's makeup. Those with good character will make every effort to repay a loan and will be open about financial difficulties. Those lacking in character assign a low priority to repaying debts and are quick to renege on any loan commitment at the first sign of trouble.

The character attribute is the reputation, conduct or judgment of the firm. Does the borrowing firm have an outstanding reputation, excellent management skills and positive past credit reports? Will the borrower use the funds wisely?

Character is an inner attribute that is exhibited by such qualities as integrity, stability, and honesty. It usually takes more than one meeting to make an accurate appraisal of character. Background checks of reputation and past actions are helpful. Customers, suppliers, creditors, and others can provide valuable insight into the character of a prospective borrower.

Capacity

Loans are repaid from the cash generated during a company's operating cycle. Management's ability to generate enough cash to satisfy all obligations is defined as capacity. The capacity attribute is the inflow of resources, or the ability to pay when obligations are due. For the firm, is the current and projected future income sufficient to cover the debt amortization? Is the income reasonably assured to continue? Here, we are mostly interested in cash, not profits, which may still remain in accounts receivable or inventory.

Capacity also refers to the ability to manage cash. It is easier to evaluate the capacity of an established company. Past financial performance and reputation in the industry are good indicators of how well it is run. It is more difficult to evaluate the capacity of a new business. It is important to look at the past business dealings of the proposed management and how those businesses fared. Also, the work experience among management personnel should strike a reasonable balance among such areas such as sales, production, administrative, legal, and financial. The education and experience of each member certainly has a bearing on creditworthiness.

Capital

Capital refers to the funds available to operate a business, of which there are two primary considerations: the amount of equity capital the owners have invested in the business and how effectively the total capital in the business is employed. It is usually a negative sign if the owner's equity is considerably less than the equity provided by creditors. There are exceptions, but consultants and lenders should generally be wary of a business that relies almost exclusively on borrowed funds to maintain it operations. Sufficient equity capital is particularly important in new, closely held companies, which often fail when the total amount of equity and debt is too small to finance the company's operations. The amount of capital reserves that owners can inject into a new business, if necessary, is also an important consideration.

The capital attribute analyzes the financial strength or net worth of the firm. Capital represents the retained earnings, collateral, backing or security that is available.

Conditions

This term refers to external variables, situations or restraints such as the state of the economy and the type and condition of the industry in which the borrower's business is a part. Government regulations also play a role here. Sources to evaluate conditions include newspapers, periodicals, business information services, general and mercantile credit agencies, and economic advisors. Some lenders prohibit loans to companies in certain industries where the risk is considered unacceptable or where specialized lending expertise is required. Sometimes a specific industry may be required to
meet a higher standard of creditworthiness.

Collateral

Collateral is an important part of the five Cs because it can be pledged by a borrower as a way of offsetting weaknesses in the other Cs. It must be kept in mind, however, that collateral itself does not repay loans and therefore is not by itself justification for making a loan. The purpose of collateral is to provide the lender with a secondary source of repayment if the cash for repayment does not materialize in the normal operating cycle of the business. Collateral is sometimes considered part of the capital attribute, so some lenders may talk of the four C's instead of the 5 C's.



Detailed Questions for the Borrower


The Borrower and the Company

• What is the borrower's name?

• Is the borrower's company a corporation, S corp., LLC, proprietorship, or partnership?

• Where is the company located?

• How long has the company been in business?

• How long has this company been in operation?

• What are the company's products or services?

• Who are the principal owners and how many shares does each own?

• Is management separate from ownership? If so, who are the principle managers?

• What is the experience of management?

• How many employees are there?

• Are the workers unionized?

• What is the company's position in the industry?

• Is the company profitable?

• Is the company well capitalized?

• Will personal assets be pledged as security for the loan?

• Who are the major suppliers and customers and what are their addresses?

• What are the normal terms of trade?

• Are any contracts or franchises involved?

• Are any items currently in dispute or litigation?

The Loan Request

• How much money does the borrower want?

• How much money does the borrower need?

• How did the borrower arrive at the amount of the loan request?

• Has the borrower accurately projected financing needs?

• What terms is the borrower requesting?

• Are the terms reasonable based on the nature of the loan - for example, within the useful and depreciable life of the asset being financed?

• How did the borrower decide which terms were best for him or her?

• Are the terms based on the borrower's company ability to pay or on good financial planning?

• How will the borrower and/or his company use the proceeds of the loan?

• Is the purpose of the loan compatible with a potential lender's policy?

The Borrower's Ability to Repay the Loan

• How will the borrower repay the loan?

• How much cash is the borrower's company generating from its operating cycle?

• Can the borrower's company provide a specific source of repayment?

• Is this specific source of repayment based on reasonable assumptions?

• What is the borrower's secondary source of repayment if the primary source fails?

• Are there guarantors? If there are guarantors, what is their relation to the borrower?

• What is the financial strength of the guarantors?

The Collateral

• What collateral does the borrower intend to pledge?

• Who owns the collateral?

• Where is the collateral located?

• How liquid is the collateral?

• Is the collateral controllable and resalable?

• Are any special permits required to take title to or to sell the collateral?

• How is the collateral valued and does the value of the collateral fluctuate?

• Is the collateral for a special purpose? 

• Is the collateral perishable?

• How long would it take to foreclose on the collateral?

• What are the actual and potential costs of maintaining the collateral?

The Borrower's Banking & Lender Relationships

• What banks does the borrower currently use?

• What lender(s) does the borrower currently have relationships with?

• Has the borrower approached other banks or lenders with the loan request?

• How does this loan fit into the borrower's and/or his company's total banking and lending picture?

• Why is the borrower approaching the lender now?

• Does the borrower have loans outstanding with other lenders?

• What is the nature and extent of these loans?

• What is the balance and terms of these loans?

Basic Information That Borrower Should Provide

• Financial statements and reports: Income statements, Balance sheets, Funds flow statements (eg. cash flow), Interim financial statements, financial forecasts.

• Tax returns: Corporate income tax return (for 1120), Partnership tax return (for 1065), Individual tax return (form 1040), Profit (or Loss) from business proprietorship (schedule C of form 1040).

• Management reports: Operating and capital budgets, Inventory analyses, Accounts receivable and payable analyses, sales and expense analyses.

• Business plans: Executive summary; Product/service description; Industry, market, and economy prospects; Marketing, Production, Management, and Financial plans. Personal financial statements: needed if borrower will personally guarantee loan.

• Other Documents: Annual report (10K), brochures,
  resumes, etc.

Five Questions Every Money Source Asks


1. How much money do you need?

It is important to be specific about the amount of money that is being sought. This will help set a framework for further discussions and demonstrate your knowledge of the deal and its requirements.


2. What do you plan to use it for?

Lenders and investors will always want to know how you plan to use their money. Is it needed for working capital? For marketing, or buying out a partner? Will it be used to purchase some commercial real estate property? The answer to this question will communicate the priorities of the project or business in question.


3. How will this money improve the business?

Lenders and investors want to see how their loan or equity lowers operating expenses, expands capabilities, moves the borrower closer to being self-sustaining. Cash flow projections are needed that will convince the lender/investor of the benefits of the capital.


4. How are you going to pay it back?

Understanding how the loan will be paid back from cash flows is usually the first thing a lender looks at. Collateral is used only as a secondary source. Even equity investors will want to know how and when they might become liquid.


5. If Plan A doesn't work, what's your backup plan?

If your business runs into trouble, a back-up plan should be considered. Other options for generating revenue will enhance the position with the lender or investor.



How Lenders Perform A Credit Analysis on a Borrower

The fundamentals of modern credit analysis are twofold: first is the examination of the nature of the borrower's business in the context of its industry, and second is the analysis of cash flow. The purpose of the former is to understand the comparative market position of the firm, the pressures of competition, the risk and reward structure of the industry, the barriers to entry, the degree of technological change, and so on. The purpose of cash flow analysis, on the other hand, is to disentangle from financial statements based on historical accounting principles the actual movements of cash in terms of its sources and uses. Once these past sources and uses have been examined, a reasonable estimate can be made as to future sources and uses, and this can be combined with the understanding of the borrower already gained to permit a judgment to be made as to the borrower's creditworthiness.

To gather information about the borrower and his or her business, references are checked and the business and industry are researched. The materials and documents obtained from the prospective borrower are studied and analyzed. Next, the people and firms the borrower has business relations are contacted. These would be the customers, suppliers, creditors, banks, and others who are in direct contact and are currently doing business with the borrower. Then reports and other materials compiled by private and public entities are reviewed. These entities would be commercial credit reports, industry comparative studies, industry trade journals, investment guides, and so on.

The borrower's relationships with other credit institutions is researched. Inquiries to commercial banks, mortgage lenders, commercial finance companies, and other financial institutions can establish deposit size; amount, type, and security for loans outstanding; borrowing history; payment habits; and the borrower's character. Trade checks are used to ascertain to what extent the company relies on its suppliers to finance current assets and how those accounts payable have been handled.

Reports about a potential borrower can be ordered from a number of commercial credit agencies such as Dun & Bradstreet, Inc., which provides information on several million businesses, including name, address, finances, history, operations, management, branches, bill-paying practices, and transactions with other businesses. Another resource for trade payment information is the National Credit Information Service (NACIS) and TRW Credit Data.

There are a multitude of magazines, books, periodicals, and other materials that are available for use in a credit investigation. The Encyclopedia of Associations, published by Gale Research, assists in obtaining information about various businesses or industries through the appropriate association. Two other general information resources are How to Find Information About Companies, published by Washington Researchers, which lists numerous private and public sources of information, and the Encyclopedia of Business Information Sources, published by Gale Research.

Also available are the Dun & Bradstreet Reference Book of Manufacturers and the Dun & Bradstreet Reference Book of Corporate Managements. Investment manuals, such as those published by Moody's Investors' Service, Inc. and Standard & Poors Corporation, also help in the analysis of the financial strength of a company.

Several resources of note determine how one business compares with others in its industry. Robert Morris Associates publishes the Annual Statement Studies, which list composite financial statements data and key ratios for over 300 types of businesses. Comparing a company's performance with that of others in its industry leads to a good understanding of that company's strengths and weaknesses. The Annual Statement of Studies includes a comparative bibliography useful for obtaining information on a specific industry. Other resources of merit include Dun & Bradstreet's Cost of Doing Business - Corporations and Cost of Doing Business - Proprietorships and Partnerships and Prentice Hall's Almanac of Business and Industrial Ratios.

Uniform Commercial Code (UCC) filings and other information can be found in records at the office of the county clerk, at the state level, or at courthouses at the state or federal level. These records include ownership, pledges, and transfer of real and personal property such as deeds, mortgages, liens, and wills; assessed valuation of property for tax purposes; corporate charters; and suits, judgments, and other judicial proceedings. Bankruptcy proceedings are recorded in federal district courts. Another good source of information are the reports (10K and others) that must be filed with the SEC by most major corporations.

Federal and state government agencies publish numerous books, periodicals, indexes, and other resource materials that can be of use the credit investigation. State departments of commerce are good sources of information. On the federal level are publications by the Bureau of Census, Bureau of Agricultural Economics, Bureau of Foreign and Domestic Commerce, Bureau of Labor Statistics, Board of Governors of the Federal Reserve System, the Internal Revenue Service, and the Department of Commerce. A listing of federal government publications and the price of each can be obtained by writing to the Superintendent of Documents, U.S. Government Printing Office, Washington DC 20402.

Other places that the credit investigator can turn to for credit information includes banking and trade associations, insurance agencies and bonding companies, and local Better Business Bureaus.

There are strict guidelines for the exchange of credit information. Credit information should be handled with total confidentiality and complete accuracy. Each inquiry should specifically indicate its purpose and the amount involved. If litigation is involved that fact must be stated. Proper identification of the inquirer must be provided. Soliciting is not permitted. Responses should be prompt and contain sufficient facts commensurate with the purpose and amount of the inquiry; no omission of facts in order to mislead or misrepresent is permitted.. All credit correspondence should bear the manual signature of a responsible party.


Loan Risk Rating Standards

The following table is an example of how business lenders will review and rate your loan request, along with the documentation you have supplied them.

Loan Rating Based on Total Score: 
(the higher, the better rating)

Credit Profile Rating

Use the Credit Profile Rating table below to judge and qualify yourself for a business loan or investment by placing an "x" in the appropriate column.

For a more in-depth look at qualifying for business financing, please look at Overall Quality Assessment to Obtain Financing.

Indicators of Problem-Type Loans

Here are some indicators which alert lenders and investors to possible future problems:

• Large amounts owed to other lenders

• Previous judgments or garnishments

• Legal action or proceedings underway

• Frequent job changes

• Heavy alimony or separation payments

• Prolonged illness

• No checking or savings account

• History of bankruptcy

• Frequent moves of residence

• Large number of dependents

• No telephone

• No references

• No auto, home, wife, husband

• Poor collateral

When a loan application or credit statement shows one or more of the above indicators, beware! While a loan application or credit statement might have several of these indicators and still be acceptable, in general it will not be passable.


Warning Signs Lenders & Investors Look for from Financial Statements

Lenders do an analysis of the borrower's financial statements to reveal any symptoms of a potential problem loan. Comparing income statements and balance sheets from year to year (or period to period) or with an external standard/average is performed to spot trends that lead to a difficult or problem loan. Ratio analysis, by looking at the relationship between one or more income statement or balance sheet accounts, can reveal poor coverage, liquidity, leverage, activity, and profitability positions. Cash flow statements help uncover any problems the borrower might have in obtaining adequate cash to finance operations and repay debt. Some of the early financial warning signs that lenders pay attention to and closely observe include the following:

• Failure to receive statements in a timely fashion

• Slowdown in receivables collection period

• Deterioration in borrower's cash position

• Sharp increases in dollar amounts or percentage of accounts receivable

• Slowdown in inventory turnover

• Decline in current assets as a percent of total assets

• Deterioration of the liquidity/working capital position

• Marked changes in mix of trading assets

• Rapidly changing concentrations in fixed assets

• Large increase in reserves

• Concentrations in non-current assets other than fixed assets

• High concentration of assets in intangibles

• Disproportionate increases in current debt

• Substantial increases in long-term debt

• Low equity relative to debt or increasing debt to equity ratio

• Significant changes in balance sheet structure

• Presence of debt due to or from officers and stockholders

• Unqualified audit

• Change of accountants

• Declining sales

• Rapidly expanding sales

• Major gap between gross and net sales

• Rising costs and narrowing profit margins

• Rising sales and falling profits

• Rising levels of bad debt losses

• Disproportionate increases in overhead relative to sales

• Rising levels of total assets relative to sales or profits

• Operating losses

• Extended average age of receivables

• Changes in credit policies

• Extended terms to customers

• Replacement of accounts receivable with notes receivable

• Concentration of sales

• Compromise of accounts receivable

• High percentage of seriously past-due accounts receivable

• Receivables from affiliate companies

Warning Signs that Lenders & Investors Look for in the Borrower

Lenders like to gather non-financial clues that may indicate a potential difficult to fund and/or problem loan. Some early warning signs, such as poorly maintained equipment, deteriorating inventory, or underutilized personnel, would be spotted during a plant or on-site visit. Also, a lender will ask both pointed and indirect questions which probe for some personal or financial difficulty that would not have appeared on an income statement or balance sheet. Some lenders like frequent contacts with the potential borrower that can provide important advance information about a company's condition. Early warning signs that lenders look for during telephone calls, meetings, plant visits, and other contacts with the borrower include the following:

• Changes in behavior or personal habits of key people

• Marital problems

• Change is attitude toward the lender, especially a seeming lack of cooperation

• Failure to perform personal obligations

• Changes in management, ownership, or key personnel

• Illness or death of key personnel

• Inability to meet commitments on schedule

• Recurrence of problems presumed to be solved

• Inability to plan or to put plans into action

• Poor financial reporting and controls

• Fragmented functions

• Venturing into acquisitions, new business, new geographic area, or new product line

• Desire and insistence upon taking business gambles and unwarranted risk

• Unrealistic pricing of goods and services

• Neglect or discontinuance of profitable lines

• Delay in reacting to declining markets or economic conditions

• Lack of visible management succession

• Excessive growth that strains the capacity of the owner to manage and control

• Labor problems

• Change in the nature of the company's business

• Poor operating controls

• Inefficient plant and equipment layout

• Poor use of people

• Loss of key product lines, franchises, distribution rights, or supply sources

• Loss of one or more major, financially sound customers

• Substantial jumps in size of singe orders or contracts that would strain existing productive capacity

• Speculative inventory purchases that are out of line with normal purchasing practices

• Poor maintenance of plant and equipment

• Deferred replacement of outmoded or inefficient plant and equipment

• Evidence of stale inventory, large levels of inventory, or inappropriate mix of inventory

Other Warning Signs that Lenders & Investors Look for Concerning Potential Trouble

• Insurance cancellation notice

• Legal notices for such things as tax liens, judgments, or garnishments

• Delayed payments to trade suppliers 

• No funds available for payment on payroll checks

• Merchandise sold to the borrower under a purchase money security interest

• Cash-on-delivery sales

• Declining bank balances

• Excessive note renewals or unanticipated note renewals

• Sharp jumps in the size or frequency of loan requests

• Poor financial planning for fixed-asset requirements or working capital requirements

• Heavy reliance on short-term debt

• Loans where the purpose is simply working capital

• Appearance of other lenders, especially collateral lenders

• Overdrafts and/or returned checks

• Evidence of checks written against uncollected funds

• High inventory levels

• Delinquent loan payments

• Legal actions against the borrower and/or the company

Twelve Problem-Borrower Types

The following 12 types of borrowers are what lenders categorize as problem borrowers. Many lenders carefully review and analyze the borrower to see if he/she fits any of these categories. The borrower is advised to review these categories and to be careful to avoid giving the lender an impression that he/she is one of these problem borrower types.

1. The sales-oriented management team. Nothing really matters but sales. A balanced support of their operations through additional capital and debt, both short and long term, is far from their thoughts. All problems can be miraculously solved by higher sales volume.

2. The silent borrower. The amount of essential information this borrower provides varies proportionately with the size of the appetite for the lender's money.

3. The crises borrower. This borrower needs the loan today to cover a federal tax payment. A check is already in the mail. Or this borrower invariable has to borrow on the 12th of the month because the collections expected on the 11th did not come in and the 12th is payday.

4. The statistical borrower. This one inundates you with figures, oral and written. When finished talking in dollars, he or she moves over to the percentages. Timetables are precise. Everything is in absolutes. There are no parameters and no tolerances for deviation. There is no such thing as an intangible, an emergency, an unexpected happening. To question the validity of the figures is unthinkable. Oh, yes - the borrower's personal checking account doesn't balance.

5. The misunderstood borrower. This one's present bank or finance company doesn't understand the nature of the business, its needs, or very much else when the chips are down. Under pressure, this borrower may admit to being asked to make other financial arrangements, but that too, is a misunderstanding.

6. The temporarily distressed borrower. This one's troubles always seem to run in multiples and you hear every one of them. Nothing is omitted in the telling. All problems are temporary and easily solved. All it really takes is a combination of the borrower's brains and the lenders' money.

7. The philanthropic borrower. This one's not very large but has lots of banks or other lenders. He or she borrows a little from you and a little from everyone else. This way, if the firm goes under, none of the lenders will be hurt very badly.

8. The future equity borrower. This is the no-risk loan. The lender can't lose on this one. If conventional sources of repayment fail, the borrower always has plans in the works for the acquisition of new capital. In its most virulent form, the future-equity disease causes the borrower to talk incessantly about plans for going public. Invariably, the public hasn't been consulted about these plans.

9. The budding giant. These buds are usually a long way from full bloom. They are young, unseasoned companies, all too often in exotic phases of electronics, aerospace, or research. Bringing them into blossom normally will require fantastic amounts of the lender's money. But don't worry - someday the lender will have the account of a major conglomerate. Then it will get the effective
yield it so richly deserves.

10. The dinosaur. This borrower hasn't really failed to keep up with the marketplace. He or she is merely waiting for it to swing back. There are reminiscences about past glories. New products are all fads, and money spent on R&D is wasted. Old inventories aren't liquidated because somewhere, someday, a buyer will come along and meet the asking price. The buyer might be an antique dealer.

11. The reassurance borrower. This one admits the figures look awful. The lender wouldn't be expected to make a loan an anything that bad. But this borrower has the best endorser in the world ready and willing to sign on the dotted line. And if one isn't enough, as many as you need can be obtained to make the deal palatable.

12. The confidential borrower. This one will tell you anything you want to know and show you anything you want to see. After all, the borrower trusts you. But it is all off the record, and you can't have a copy of what is in print. He or she doesn't trust the suppliers or the IRS and can't take the risk that the competition might learn something of value.


Summary Bullets of Important Information the Lender will Look for

• How much is the borrower looking for?

• What will the funds be used for? 

• What period of repayment (term of loan) is required, and/or how much per month can the borrower afford to pay back?

• What collateral is available for security?

• If this is a new business start-up or expansion, how much of his own funds will the borrower be investing?

• What is the borrower's equity situation, or the debt-to- equity ratio?

• Does the business borrower have a current business plan?

• If not, does the business borrower require assistance in preparing one?

• How current is the borrower's financial statement, and is it audited or unaudited?

• Does the borrower have good credit?

• How much down payment can the borrower make?

• From what source will the borrower repay the loan?